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Should you hold rental property in an LLC?

Posted by John T. Reed on

No. You should not hold rental property in an LLC (limited liability company). 

Real estate investing has more BS artists than other businesses

So why is doing that extremely popular? Because real estate investing is a unique business in that it has an extraordinary large number of scammers—get-rich-quick gurus selling seminars and “mentoring” services and actual properties, cable TV flipping shows, and novices who do not know what they are doing, but who nevertheless prattle on about such things in internet-discussion groups.

See my guru-rating article and my Real Estate BS Artist Detection Checklist.

I have another broader article on all the various entities some use in real estate and the difficulty of picking one other than sole proprietorship

Advantages

Only protects assets and/or income outside LLC

The purpose of an LLC is to limit a person who sues you successfully to collecting from the assets within the LLC. Normally, a person who successfully sued you could collect the judgment against all your assets and/or income. The LLC tries to limit the judgment creditor only to the assets within the LLC.

So if you have no other assets or income, an LLC accomplishes nothing for you.

A whole lot unprotected

Say you live in and own a $300K duplex and buy another rented out $330K duplex. Each is in its own LLC.

Me: “Why the LLC?”

You: “A person who sues me can only get the property in the LLC if they win.”

Me: “‘Only?’ It’s half your net worth.”

No lawyer

You do not need a lawyer to form an LLC.

Estate heirs

A family LLC allows your heirs to become shareholders who can then benefit from the assets held by the LLC, while you retain management control.

The estate tax benefit of the LLC lies in the fact that the value of the shares transferred to heirs can be discounted steeply, often up to 40% of their market value.

Look like a business—with deep pockets

Some say using an LLC impresses people because it makes you look more like a business. You have to name it for one thing. Are you going to give it some grandiose name to make you seem like a big shot—like “Wilkerson Properties.”

A. No, it does not make people think more highly of you. Real businesses buy larger quantities, behave professionally, and did not just appear on the local scene.

B. An LLC does make you look more like a deep pockets, lucrative lawsuit target. That is a bad thing.

Protects you from liability for your co-owners acts

LLC protects its owners from personal liability for any wrongdoing committed by the other  owners or employees of the LLC. The owner or employee who broke a law might be personally liable, but a co-owner of the LLC who was not involved in the violation would not be.

A simpler way to achieve that would be to not have any co-owners.

LLC does not protect you from your own wrongdoing

You are personally liable for any wrongdoing you commit in your LLC business, e.g.,

  • personally and directly injure someone during the course of business 
  • fail to deposit taxes withheld from employees' wages
  • intentionally do something illegal during the course of business that causes harm to the LLC or another
  • treat the LLC as an extension of your personal affairs, rather than as a separate legal entity
  • fail to follow required formalities in LLC actions

Your LLC itself may sue you

Note that third item. Many think the LLC protects them from lawsuits. If the LLC has other members, the LLC itself may sue you. So a multimember LLC is a potential additional source of lawsuits.

Disadvantages

Must file with the state and pay annual fees

An LLC is a formal partnership arrangement that requires articles of organization to be filed with the state. It also should have an operating agreement as a practical matter.

State laws generally provide automatic "default" rules for how an LLC will be governed unless the operating agreement provides otherwise.

Income tax implications

An LLC is a disregarded entity (for federal tax purposes), if it has only one member. [Single member limited liability company (SMLLC)]

Also, SMLLCs are more vulnerable to charging orders, foreclosure of the LLC, or court-ordered dissolution of the LLC. (See below)

An LLC may be taxed as a corporation. Ouch. Very bad and complex mess that.

If it is in California, the LLC must have the same designation for state and federal tax purposes.

Every LLC that is doing business or organized in California must pay an annual tax of $800. Other states also have such taxes on LLCs.

If the LLC claims to be a partnership, it must file Form 1065.

If it has chosen to be treated as a corporation, it must file Form 1120.

The LLC must send a K-1 Form to each member annually informing them and the IRS of their share of the LLC’s income.

LLC fees

If your California LLC will make more than $250,000, which it very likely will in the year when you sell the property, you will have to pay a fee. LLCs must estimate and pay the fee by the 15th day of the 6th month, of the current tax year.

If the total California income rounded to the nearest whole dollar is: The fee amount is:
$250,000 - $499,999 $900
$500,000 - $999,999 $2,500
$1,000,000 - $4,999,999 $6,000
$5,000,000 or more $11,790

 

If you do not make your estimated LLC fee payment by the original return due date, you will be subject to penalties and interest

A California LLC must file Limited Liability Company Return of Income (Form 568) by the original return due date.

If you have income or loss inside and outside California, use Apportionment and Allocation of Income (Schedule R) to determine California source income.

To keep a California LLC active you must:

  1. File the Statement of Information with the SOS
  2. File and pay your state income taxes

SOS imposes a $250 penalty if you do not file your Statement of Information.

Documents and fees must be submitted at the federal level to obtain an employer identification number (EIN).

Depending on elections made by the LLC and the number of members, the IRS will treat an LLC as either a corporation, partnership, or as part of the LLC’s owner’s tax return (a “disregarded entity”). 

A domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it files Form 8832 and affirmatively elects to be treated as a corporation.

For purposes of federal employment tax and certain excise taxes, an LLC with only one member is still considered a separate entity.

Cannot represent yourself in court in many states

In many, if not most, states, an LLC member cannot represent himself in court. That means he must hire an attorney to represent the LLC in every court matter including small claims court.

Exceptions to LLC protections

If fraud is detected or if an LLC fails to meet its legal and reporting requirements, creditors may be able to go after the members.

If you cosign on an LLC loan, you are as responsible as the LLC to pay it back.

If you agree to pledge your house or other personal assets as collateral for the LLC loan, the creditor can take your house and/or other personal assets.

Whether and how much your personal liability is reduced by having an LLC involves four possible paths to your outside the LLC assets and/or income:

• your liability for LLC debt

• your liability for actions by LLC co-owners or employees related to the business

• your liability for your own actions related to the business, and

• the LLC's liability for other members' personal debts

‘Piercing the corporate veil’

A successful plaintiff can try to go after your personal assets and/or income by eliminating the limited liability protection. This is called “piercing the corporate veil.

The corporate veil is pierced if the successful plaintiff proves the LLC was a shell created only to provide liability protection for its owners or the company was practically inseparable from or an alter ego of its owners.

When deciding whether to let the person who successfully sued you to get your other assets or income, the court will consider whether

  • Formalities, such as holding annual meetings and keeping minutes, were not followed.
  • Owners exerted too much control over the LLC.
  • Owners commingled personal funds with LLC funds or used personal funds to pay LLC bill.
  • The company was thinly capitalized (hardly any assets) when formed.

If the owner made fraudulent representations or omissions when applying for an LLC mortgage, he or she can be held personally responsible for the mortgage.

If creditor cannot pierce the LLC veil, he may be able to TAKE OVER your LLC

A judgment creditor could also get at the assets of the LLC without piercing the corporate veil, depending upon the state, by:

1. getting a court to order that the LLC pay to the creditor all the money due to the LLC owner from the LLC ("charging order")

2. foreclosing on the owner's LLC ownership interest which would have the LLC itself auctioned off and the judgment creditor could bid the amount of its judgment at the auction and if they were the winning bidder, they would replace you as the owner of the LLC and they would then own it lock, stock, and corporate veil

3. getting a court to dissolve the LLC

If an LLC was created to commit fraud, a court can pierce the corporate veil to let the successful plaintiff go after the owners.

LLC ends on death or bankruptcy

An LLC generally has to be ended upon the death or bankruptcy of a member. 

LLC protection lost if insolvent due to distributions

LLC members may be personally liable if distributions to members rendered the LLC insolvent.

Some people think that that LLCs have a tax benefit. They do not. Income from the LLC is taxed at the tax rate of the person(s) who own the LLC.

Does not prevent lawsuits or pay for them

Some people think the LLC prevents lawsuits against the LLC. That is not true. At best, the LLC may limit the assets the person who sued can get to what is in the LLC. To protect yourself from lawsuits, you need liability insurance.

In CTLLC members can be personally liable for operation of the LLC [Sturm v. Harb Development, 298 Conn. 124, 2 A.3d 859 (2010)].

More than one property in one LLC?

Some real estate investors put all their properties in one LLC. Apparently, they do not understand the purpose of an LLC. It limits creditors to what is in the LLC. If you put all your properties into it, it only protects personal property that you own like cars and clothing.

LLCs get worse mortgages

It is harder for an LLC to get a mortgage and the terms of the mortgage will generally be less attractive than the terms for an owner-occupied principal residence.

Many lenders don't want to lose money if your LLC goes under so they will insist that you personally guarantee any LLC loans, credit cards, or other extensions of credit to your LLC. If you do, that renders the LLC meaningless regarding the lender being able to go after your other assets and/or income.

No LLCs in Canada

Canada does not allow LLCs.

Sole proprietorship is simpler

The simplest form of ownership is sole proprietorship, not an LLC.

Investors complex

Outside investors can invest in LLCs and receive LLC ownership interests, but this is more complicated than doing the same with a corporation.

Pension and health benefits

When it comes to pension and health benefits, a managing partner in an LLC participates like an employee and is covered under the LLC's health plan and is a participant in the partnership-sponsored retirement savings plan.  

LLC retirement plan options are the same as for any self-employed individual. They include SEPs, SIMPLE IRAs or a 401(k). As you're both an owner and employee, if you have other employees, you have to give them the option to participate in the same plan. An investor I know created an LLC, then immediately killed it when his accountant notified him of this rule.

The LLC IRA contribution limit is currently ​$58,000​. 

If you have staff working for you, the situation is more complicated. Owner-employees can't give themselves a retirement plan and not give other employees the same option. They must also be covered under the plan if they meet the eligibility requirements.

If you give yourself a SEP, every employee has to have the choice to sign up for oneRules regarding contributions can vary depending on whether the LLC is for a sole proprietor, a corporation, or has employees.

Worse mortgage terms

Lenders will want higher interest rate, more down, maybe you signed personally on the loan. Many will refuse to make a loan to LLC at all.

LLC cost your kid $100,000 in college aid

Forbes has a net article titled:

“Did Your LLC, S Corp Or Partnership Just Cost Your Kid $100,000 In College Aid?”

LLCs may let small business owners avoid the potential double taxation of C corporations, but the owner will likely end up paying an even bigger bill—the full sticker price for college for each of his or her children.  All of that income can have a very negative effect on the financial aid eligibility of a business owner's child. 

On the FAFSA and the CSS Profile, the two financial aid forms colleges use to assess a family's ability to pay for a child's college, net income is counted at 46 - 47%, nine times more heavily than what taxable assets are (5 to 5.64%).

LLC bankruptcy

When an LLC files for bankruptcy, the bankruptcy trustee will liquidate all the company's assets and distribute them to creditors. For principal residences not in LLCs, the equity is totally or partially protected by homestead bankruptcy exemptions.

LLC in divorce

If you invested marital funds in the LLC or if your spouse worked in the LLC without compensation, a divorce court might decide that the LLC is a marital asset.

If you are the spouse that is a member of an LLC you owe a fiduciary duty to the community estate which means that you must put the interests of your community estate (the estate of which you and your spouse both share in) before your own interests in conducting business related to the LLC.

LLC may hurt your SSDI

You can qualify for Social Security Disability Income if you have an LLC. But, you must also be very careful to avoid performing “significant services” for the company, or you could jeopardize your SSDI benefits. 

LLC employees

LLC owners, are self-employed according to the IRS. LLC employees are not. This requires the LLC filing returns and payroll taxes similar to every other business type.

The owners of an LLC aren't employees of the business and therefore can't be paid wages—called "W-2 income."

Employees of an LLC who receive fringe benefits, like group insurance, medical reimbursement plans, medical insurance and parking, must pay income tax on the value of the benefits.

Comparison of LLC and liability insurance

 Issue
LLC  Liability insurer
protection if you get sued might limit plaintiff to only seizing assets within the LLC covers all suits included in the policy
hire lawyer to defend you It is just a document. It takes no action. yes
takes care of everything related to the litigation
It is just a document. It takes no action.
yes
pays the lawyer
It is just a document. It takes no action.

yes

pays the judgment if any
It is just a document. It takes no action.
yes, up to the policy limit
protects assets IN the LLC no
yes, up to the policy limit
protects assets and/or income outside the LLC except in cases where the court allows the plaintiff to pierce the corporate veil or grants a charging order, foreclosure, or dissolution of the LLC
yes, up to the policy limit
annual cost state fees, CPA fees couple thousand

 

Best practice is to have property insurance as well as umbrella liability insurance. Forming an LLC is not a best practice.

Can you have both an LLC and insurance? Yes.

But as you can see in the above table, the LLC provides just possible, but not certain, protection from a property lawsuit judgment creditor going after assets and/or income outside of the LLC.

Insurance covers all your assets and income both inside and outside the LLC up to the policy limit. Insurance also takes care of everything including hiring and paying a lawyer as well as paying the judgment. LLCs only relate to paying judgments that try to go outside of the LLCno legal fees or other litigation costs.

Furthermore, your mortgage lender will almost certainly require you to have property insurance so only forming an LLC is optional.

Comparison of rental LLC and principal residence

 Issue
LLC  principal residence
protection if you get sued might limit plaintiff to only seizing assets within the LLC homestead bankruptcy exemption protects residence equity partially or totally depending upon your state; other exemptions protect other assets
Cost of protection thousands a year free, you do not even have to do anything, it is state law
incidence of litigation Residential landlords are the most sued group in the U.S. Homeowners are almost never sued with regard to their home
mortgage terms
punitive

better than all other categories of loans

personal liability on mortgage almost certainly often protected by state anti-deficiency judgement, one-action laws, or RAM terms
discounts on property taxes no
yes, for homestead, seniors, veterans, and other categories by state
interest and property taxes deductible generally not because of passive loss limits; have to wait until later years or until you dispose of all interest in the property
Yes, if you itemize on first $750,000 of mortgage interest and HELOC interest only if you used the HELOC money “to buy, build or substantially improve the taxpayer’s home that secures the loan,”  and first $10,000 of property taxes—the standard deduction may be more than itemizing
Medicaid eligibility affected by equity yes, reduced and maybe totally lost not taken into account
Long-term care eligibility affected by equity
yes, reduced and maybe totally lost
not taken into account
College financial aid eligibility affected by equity
yes, reduced and maybe totally lost
not taken into account

 

 

Conclusion

If you have an LLC, get rid of it. If you don’t have one, don’t get one. You are also better off overall putting all your real-estate investing money into one principal residence at a time and aggressively moving up to a more valuable one as your finances permit.


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